How to Spot a Bubble in Stocks

Have you ever noticed that equity investors can't have nice things? As miserable as we are when stocks are going down, we're even more unhappy when they're going up. 

There's an empirical explanation for this psychological phenomenon. It's called loss aversion. Humans are at the mercy of all sorts of cognitive biases, and one of the more perverse ones is that we experience far more pain from losing money than we experience pleasure from winning the exact same sum.

That's why when markets are rising, stocks are said to be climbing a wall of worry. The higher stocks climb, the more investor anxiety mounts. That's loss aversion at work.

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Cut to today, with markets at record highs and valuations stretched by just about any metric you care to use, and it's only natural for investors to question if stocks are in a bubble.

After all, stocks never go up in a straight line, but that's pretty much what the S&P 500 did after bottoming out in late October 2023. The benchmark index is up about 40% on a price basis ever since. Such a torrid run has U.S. equities trading at some of their very priciest levels in history, according to BofA Securities.

"The S&P 500 is statistically expensive on 19 of the 20 metrics we track and is trading at its 95th percentile based on trailing P/E, based on data since 1900," writes Savita Subramanian, head of U.S. equity strategy and U.S. quantitative strategy at BofA Global Research, in a note to clients.

Is the stock market in a bubble? Here's how to tell

Happily, valuation is not a timing tool, as strategists take pains to point out. Subramanian actually argues that the market isn't quite as richly valued as it appears at first blush. Perhaps most importantly, bubbles are as much of a psychological phenomenon as a financial one. 

There's no substitute for experience on Wall Street, which is why it's always wise to listen to old hands when it comes to divining the market's machinations. Nicholas Colas, co-founder with Jessica Rabe of DataTrek Research, started working full-time on Wall Street in 1986. He lived through the October 1987 stock market crash and has witnessed every boom and bust up close ever since.

Colas has developed a three-point checklist for "spotting unhealthy, runaway markets." Here's a thumbnail version:

The market for initial public offerings gets frothy. "Why is the IPO window still largely shut? For one, most of the largest IPOs in 2021 were mispriced during the pandemic driven spec tech bubble and have since fallen sharply from their IPO valuations," Colas writes. "This year's IPOs have been mixed, at best. Some companies are also waiting until at least 2025 to go public given recent equity market volatility and uncertainty about the U.S. presidential election. The good news is that history shows a rampant IPO market is a clear sign of a top. We're nowhere close to that now."

Hallmark mergers and acquisitions (M&A) deals. "Exceptionally bad deals happen at the top, even if at the time they seem quite sensible," Colas writes. "M&A activity is ultimately a function of CEO/board confidence. Just like retail investors chasing hot IPOs at a market peak, senior managers fall prey to the same overconfidence that the good times will last forever."

Happily, M&A activity is only picking up now after a slow 2023, Colas says, "a good sign that equity markets are not yet in bubble territory."

A double is a bubble. Colas has a simple rule of thumb to identify unsustainably high prices in a range of markets. Whenever the S&P 500 doubles in three years or less, stock prices decline shortly thereafter. The same is true about the Nasdaq Composite over any rolling one-year window going back to the early 1970s, notes Colas.

"A double is a sign of speculative excess because macro conditions are never so different that asset prices should rise 100% over a short period of time," Colas says. "Markets are reasonably good discounting mechanisms. When prices double, you know speculation – not fundamentals – are driving those gains."

Even the Nasdaq Composite, which is the frothiest equity market right now, is up "only" 37% over the past year.

Another tech bubble?

The remarkable bull market in equities was given fresh fuel by the Federal Reserve's jumbo interest rate cut, but bubble anxiety centers around the AI companies, such as the Magnificent 7, that dominate the S&P 500 and Nasdaq-100.

Naturally, echoes of the bursting of the dot-com bubble are top of anxious investors' minds. 

The introduction of transformative technologies typically attracts growing investor interest as well as significant capital and new competition," writes Peter Oppenheimer, chief global equity strategist and head of macro research Europe at Goldman Sachs. "As enthusiasm builds and stock prices increase, the sum of individual company valuations can overstate the total potential aggregate returns; often a bubble develops and bursts."

Oppenheimer notes the technology sector has generated 32% of the global equity return and 40% of the U.S. equity market return since 2010. But this reflects stronger fundamentals rather than irrational exuberance.

"In our view, the technology sector is not in a bubble and is likely to continue to dominate returns," the strategist adds. That said, "concentration risks are high and investors should look to diversify exposure to improve risk-adjusted returns while also gaining access to potential winners in smaller technology companies and other parts of the market."

Are stocks in a bubble?

None of Colas' time-proven indicators point to a stock market bubble, but a bubble very much remains a possibility next year, Colas says. Keep an eye on IPOs, M&A and how fast market levels rise from here.

Also remember that while the explosive growth in all things AI has valuations looking stretched, Goldman Sachs' Oppenheimer notes, "valuations often also understate the opportunities that can accrue in the non-technology industries that can leverage the technology to generate higher returns."

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